VISUAL PLANNED GIVING:
An Introduction to the Law and Taxation
of Charitable Gift Planning

15. Donating Retirement Assets, Part 1 of 2

Links to previous sections of book are found at the end of each section.

Donating retirement assets can result in terrible tax consequences or fantastic tax consequences depending upon the timing and circumstances of the donor. Thus, it is especially important for advisors and fundraisers to have some familiarity with the tax rules associated with such gifts.

Given the inherent complexity in dealing with retirement assets, some might consider simply ignoring these assets as a source of charitable gifts. Rules for traditional IRAs, 401(k) accounts, 403(b) accounts, SIMPLE-IRAs, SEP-IRAs and so forth may seem intimidating. However, retirement assets should not be ignored. This is true in part because the client can experience significantly positive tax consequences from such gifts in certain circumstances

Aside from these potential tax advantages, retirement assets cannot be ignored because they represent such a large share of all household wealth. More than a third of all household financial assets are held in the form of retirement assets. Thus, neither fundraisers nor advisors should ignore this substantial source of wealth holding.

Retirement assets can be donated during life or at death. The tax consequences are very different for each type of gift, so they will be covered separately. Gifts during life involve more complicated considerations and their advisability depends in part upon the “life stage” of the retirement account.

Retirement accounts such as traditional IRAs, 401(k) accounts, and 403(b) accounts have three stages. Each stage corresponds to a different tax consequence of gifting assets from the account. Before the account holder reaches age 59½, distributions will be considered early distributions, and are typically subject to penalties for withdrawal. When the account holder reaches age 59½, these penalties no longer apply. However, as with other distributions from the account, the account holder must pay taxes on these distributions, because the income was not taxed when initially put into the account. Finally, when the account holder reaches age 70½, he or she is required to take at least minimum distributions from the accounts each year. These distributions count as taxable income to the donor.

For donors younger than 59½, making gifts from a retirement plan is generally a bad idea. Not only will the withdrawal be considered income to the donor, and thus be subject to taxation, but the donor will also have to pay an additional 10% penalty. This penalty is charged because the donor is withdrawing assets from the account prior to age 59½. The donor may receive a charitable deduction from the gift. This deduction could offset the income charged to the donor as a result of withdrawing the funds. However, this charitable deduction will not offset the 10% penalty charged for early withdraw.

The charitable deduction resulting from the donation will not offset the 10% penalty for the early withdraw. Thus, even in a perfect situation, making a $10,000 gift by withdrawing funds from the retirement account will cost the donor at least $11,000. Beyond this, it is often the case that the charitable deduction may not perfectly offset the effects of the increased income resulting from the withdraw of funds. For example, if the donor was not otherwise an itemizer, the charitable deduction for a $10,000 gift will not reduce income by the full $10,000. Or if the donor is in the range of income where Pease amendment rules result in a reduction of such deductions, the charitable deduction for a $10,000 gift will not reduce income by the full $10,000. Or, if the donor reaches the income limits for deducting charitable gifts, the deduction will be not be available until future years.

Further, the increase in income, even if offset by deductions, may generate other negative tax consequences because certain tax benefits are not available for those whose adjusted gross income falls above specific levels. For example:

The personal exemption is reduced by 2% for each $2,500 that adjusted gross income exceeds threshold levels. (In 2016 the threshold was $259,400 for single taxpayers and $311,300 for married taxpayers filing jointly.)

The earned income tax credit is reduced for income above certain thresholds. (In 2016 these thresholds were $8,270 for a childless single taxpayer, $18,190 for a single taxpayer with children, $13,820 for childless married taxpayers filing jointly, and $23,740 for married taxpayers with children filing jointly. The credit phased out at 7.65% of income above the threshold for childless taxpayers, at 15.98% of income above the threshold for taxpayers with one child, and at 21.06% of income above the threshold for taxpayers with more than one child.)

The adoption credit ($13,460 in 2016) is reduced for those with modified adjusted gross income above the threshold level ($201,920 in 2016).

The child tax credit ($1,000 for each qualifying child) is reduced by 0.5% for any modified adjusted gross income above the threshold level (in 2016 this was $75,000 for single taxpayers, $110,000 for married taxpayers filing jointly).

Education tax benefits also phase out after certain income thresholds such as the American Opportunity Credit ($80,000 for single taxpayers, $160,000 for married taxpayers filing jointly), Lifetime Learning Credit ($55,000 for single taxpayers, $110,000 for married taxpayers filing jointly), and deductibility of qualifying student loan interest ($60,000 for single taxpayers, $125,000 for married taxpayers filing jointly).

Eligibility to make Roth IRA contributions begins to phase out after certain income thresholds (in 2016, $117,000 for single taxpayers, $184,000 for married taxpayers filing jointly), as does deductibility of IRA contributions (in 2016, $61,000 for single taxpayers, $98,000 for married taxpayers filing jointly with participating spouse, $181,000 for married taxpayers filing jointly with non-participating spouse).

For taxpayers affected by these phase-out ranges, the negative tax consequence of the increased income resulting from the retirement account withdraw will not be perfectly offset by the charitable income tax deduction. Additionally, if taxpayers are eligible for other income-based government benefits, the increase in income resulting from the retirement account withdraw may have additional negative consequences.

Withdrawals made after age 59½ do not generate the 10% penalty as do those made before this age. Consequently, it is possible that the deduction generated by making a corresponding charitable gift could completely offset the effects of the increased income due to a withdrawal from a retirement account. As before, the ability to completely offset the effects of the increased income with the charitable tax deduction depends upon a variety of factors such as the donor’s itemization status, the income giving limitations, and whether or not the increased income will have negative effects for the donor in other areas such as income-based phase outs for various tax benefits.

Withdrawals after age 70½ receive the same tax treatment as those taken at any point after age 59½. The primary difference is that minimum withdrawals are required beginning at age 70½. Thus, the account holder cannot simply choose not to take a withdrawal. Instead the account holder must take a minimum withdrawal in the amount of the account balance divided by the remaining years of life expectancy for a typical person of the account holder’s age. If the account holder fails to withdraw at least this amount, he or she will be taxed in the amount of 50% of the required minimum distribution.

Because the taxpayer is forced to withdraw the required minimum distribution from the retirement account, the negative tax effects from increased income will occur regardless of whether or not a charitable gift is made. The taxpayer cannot simply choose not to take a withdraw. If the taxpayer is forced to withdraw the funds, but does not need them for consumption, a charitable gift may be an ideal use of these funds. The charitable deduction resulting from the gift may entirely (or at least partially) offset the negative tax affects resulting from the increased income due to the required distribution.

The ideal charitable distribution is a qualified charitable distribution (QCD). This arrangement is ideal because the donor is allowed to make a transfer directly from his or her retirement account to a charity. This transfer does not count as income to the donor, but does reduce the required minimum distribution from the account. The donor receives no deduction, but also has no increase in income. This perfect offset makes this transaction equivalent to the “perfect” withdrawal and gift transaction with a 100% useable tax deduction and no negative effects from the increased income.

After having been temporarily approved for several years, the qualified charitable distribution is now part of the permanent tax code.

The qualified charitable distribution includes the following limitations. The participant must be 70½ or older (i.e., subject to required minimum distributions). The maximum transfer is limited to $100,000. The qualified charitable distributions must be from an IRA or IRA rollover. These are not allowed from 401(k), 403(b), SEP, SIMPLE, pension or profit sharing plans. However, the retired account holder with a 401(k), 403(b), 457 plan, SEP-IRA, or SIMPLE-IRA (assuming it is more than 2 years old) could consider rolling the account over into a traditional IRA rollover to allow for future qualified charitable distributions. This strategy will work only for qualified charitable distributions in future years because any current required minimum distribution from the non-traditional IRA account must be distributed and cannot be rolled over into a traditional IRA. Finally, the distribution must go to a public charity (not a private foundation or donor advised fund) and the donor may receive no benefits in return for the transfer. Similarly, the distribution may not go to pay for a charitable gift annuity or be transferred to a charitable remainder trust or charitable lead trust.

Distributions from Roth IRAs will be tax free in a number of circumstances. First, if the distribution is from the account holder’s regular participant contributions to the Roth IRA, there is no taxation or penalties for withdrawing funds. The account holder has already paid taxes on this amount and its contribution into or withdraw from the Roth IRA does not generate any additional taxes or penalties. Any distributions from the Roth IRA are considered to be from the account holder’s regular participant contributions until all of these have been distributed. Distributions in excess of the account holder’s regular participant contributions will next consist of distributions of any IRA conversions. A conversion occurs when the account holder converts a retirement account such as a traditional IRA into a Roth account. This conversion requires the account holder to pay income taxes on the amount of the converted account. Thus, distributions of such conversions do not generate income taxes because the income taxes on this money have already been paid. However, if the account holder is younger than 59½ and the conversion was less than five years ago, the 10% penalty on early withdraw must still be paid for these conversion assets. (If this rule did not exist, the 10% penalty on early withdrawals from a traditional IRA could be completely avoided by simply converting to a Roth IRA and taking the distribution.) Finally, all remaining distributions will be considered earnings. Distribution of earnings after age 59½ does not generate income taxes or penalties (assuming the distribution occurs at least five years after the account holder funded his first Roth IRA account). However, distributions of earnings before age 59½ typically generate both income taxes and penalties. (The 10% penalty could be avoided from either traditional or Roth IRA accounts if the funds are used for specific allowed purposes, but these do not include making charitable gifts.)

When distributions from Roth IRAs are tax free, they may make a desirable source for charitable gifts. However, this will result in reducing the amount of funds in the Roth IRA and may not correspond with the retirement tax planning strategies of the donor. For example, additional growth in the Roth IRA can be withdrawn without taxation (after age 59½) and reducing IRA assets through gifting eliminates this future tax-free growth on the gifted assets.